Soddy's Law

The name Frederick Soddy may not mean much to many people. Historians of science might recall that he collaborated with Ernest Rutherford on radioactivity and that he won the Nobel Prize for chemistry in 1921 for his research on radioactive decay. In the world of economics he occupies at best a place on the fringes despite having written four major works on the subject between 1921 and 1936. I recently dipped into his 1934 book The Role of Money (available online here) and although the prose is a little dated and some of the ideas are very much of their time (not to mention flawed), it is nonetheless fascinating to sift through his work to discover that he uncovered a number of macroeconomic ideas long before the celebrated economists of recent years. It is also worthwhile looking again at his work to determine whether it offers any insights on today's policy issues.

A man of astounding economic prescience

Although Soddy was largely dismissed as a crank during his lifetime, many of his policy prescriptions were later adopted into the mainstream. He was, for example, a great critic of the gold standard and argued strongly that exchange rates be allowed to float; he also argued in favour of using the government budget balance as a tool of macroeconomic policy and called for the establishment of independent statistical agencies to compile economic data (particularly to measure the price level). In the event, the idea of using fiscal policy as a policy tool was one of the cornerstones of the post-1945 Keynesian revolution whilst the suspension of dollar convertibility into gold in the early 1970s ushered in the era of floating exchange rates which has prevailed ever since. Moreover the UK established a Central Statistical Office seven years after Soddy first mooted the idea in 1934.

Economics as science

Soddy’s approach was rooted in physics, viewing the economy as a machine which requires inputs to derive outputs. Whilst there is a lot wrong with this way of thinking it was not out of tune with the mainstream views adopted in the post-1945 era, the echoes of which still persist today. But it is appropriate in one sense: A system which relies on such inputs will soon grind to a halt unless there is an infinite supply of them. Accordingly, Soddy’s ideas have been adopted by the modern-day ecological school of economics which views the economy less as a machine and more as a biological system.

The original motivation for his thinking was the recognition that a fractional banking system requires perpetual growth in order that the debt acquired in the process of generating today’s consumption can be repaid. As a scientist, Soddy understood that an economy based on the consumption of finite resources cannot continue to grow indefinitely since this would violate the laws of thermodynamics which prevent machines creating energy out of nothing or recycling it forever – an idea he set out in his 1926 book Wealth, Virtual Wealth, and Debt. 

Soddy recognised the fact that private sector banks create money simply by creating deposits thus inherently increasing the leverage in the system – in his memorable phrase: “Money now is the NOTHING you get for SOMETHING before you can get ANYTHING”. He further recognised that this exacerbated the swings in the credit cycle since banks were prone to call in loans when borrowers were least able to repay whilst they were most willing to grant credit when times were good and therefore when credit was least needed. Accordingly, one of Soddy’s main proposals was that the creation of money be taken out of private hands and should instead be fully backed by government created money.

Father of the Chicago Plan

Although Soddy’s ideas were generally ignored in the UK they did find support in the US. In a review of Soddy’s 1926 work, the great American economist Frank Knight noted that “it is absurd and monstrous for society to pay the commercial banking system “interest” for multiplying several fold the quantity of medium of exchange when a public agency could do it at negligible cost” particularly where there are huge costs associated with the booms and busts of the credit cycle. Influential US economists led by Henry Simons and Irving Fisher went on to formulate the Chicago Plan which advocated wholesale reform of the banking sector, notably the separation of the monetary and credit functions of the banking system, “by requiring 100% backing of deposits by government-issued money, and by ensuring that the financing of new bank credit only took place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks.”

Needless to say the Chicago Plan did not find favour in the 1930s. However in the wake of the 2008 financial crisis the idea of full-reserve (or narrow) banking did come back onto the agenda. Institutions such as the IMF have recently given serious thought to the idea, with an influential working paper in 2012 conducting quantitative analysis which concluded that “the Chicago Plan could significantly reduce business cycle volatility caused by rapid changes in banks’ attitudes towards credit risk, it would eliminate bank runs, and it would lead to an instantaneous and large reduction in the levels of both government and private debt.” The FT’s chief economics commentator, Martin Wolf, who sat on the UK’s Independent Commission on Banking, came to a similar conclusion (although he did not credit Soddy with the original insight).

Rethinking narrow banking

In recent years the debate has taken a step further with the advent of digital currencies. In theory the likes of Bitcoin represent a form of narrow banking given that its supply is fixed. However, to the extent that each Bitcoin unit is divisible into sub-units of 100,000,000 it is possible to imagine a world in which value can be destroyed by division, in which case we are no better off. But the concept of a central bank digital currency (CBDC) may be a different story. The Bank of England’s illustrative model for a Sterling CBDC utilises a two-tier intermediation model, whereby Payment Interface Providers (PIPs) would keep all CBDC reserves at the central bank. These PIPs may be pure payment intermediaries or may be commercial banks processing transactions but the key point is that these CBDC deposits would not be used for lending. Such a policy is not without risks (as I discussed in this post a year ago) and I retain some scepticism that a CBDC does many of the things that are claimed for it. Nonetheless, their introduction may take us a long way closer towards realising Soddy’s idea.

One of the reasons why economists remain sceptical of narrow banking is the conventional view that it will reduce banks’ lending activity which will in turn act as a brake on economic growth[1]. But a lot of modern macro theory increasingly calls this view into question. This paper published in September 2020 by Hugo Rodríguez Mendizábal makes the case that a “fully reserve-backed monetary system does not necessarily have to reduce the amount of liquidity produced by depository institutions.” Space considerations mean that we cannot do justice to the full implications of the case for narrow banking and it is clearly a topic for another time. Suffice to say that it is a very active research area these days.

Last word

For a man who was regarded as a crank operating at the margins of respectable economics, many of Frederick Soddy’s “crazy” ideas have subsequently found a surprising degree of mainstream acceptance. Almost a century after he sowed the seeds, the idea of a full reserve-backed banking system refuses to die and has now become a respectable topic of research. It is perhaps not surprising that many of his ideas have such modern day resonance since many of today’s global economic problems echo those of the 1920s and 1930s. Indeed, as he wrote in 1934: “There is a growing exasperation that an age so splendid and full of the noblest promise of generous life should be in such ill-informed and incompetent hands.”

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[1] Diamond, D. W., and P. H. Dybvig. 1983. ‘Bank Runs, Deposit Insurance, and Liquidity.’ Journal of Political Economy 91(3) pp401-19

The market for central bank governors

The search for a successor to BoE Governor Carney kicked off last week, ahead of his contract expiry next January, whilst jockeying for the top job at the ECB has also got underway with Mario Draghi due to stand down in November. Naturally the press has had a field day looking at the possible candidates for both positions. But less attention has been paid to the qualities necessary to be an effective central bank governor.

Over the last 30 years there has been a tendency to appoint economists to the top job. It has not always been the case, of course. Whilst former ECB President Trichet and BoE Governor Eddie George both had academic qualifications in the subject, neither would be regarded as front-line economists. But compare them to contemporaries such as Alan Greenspan, Ben Bernanke, Janet Yellen, Wim Duisenberg, Mervyn King and Draghi it is clear that a strong economics background has been viewed as an advantage. The reason for this is simple enough: Over recent years, central banks have been given a mandate to target inflation which means that they have a much closer focus on economic issues than has historically been the case.

However, I do wonder whether the unwillingness to raise interest rates – particularly in Europe – reflects the overly cautious nature of a policy-making body in which economists hold the upper hand. It was not for nothing that President Harry Truman reputedly demanded a one-handed economist in order to eliminate their tendency to say “on the one hand … but on the other.” More seriously, since the financial crisis central banks have acquired additional responsibility to manage the stability of the financial system which means that a macroeconomic background may not be the advantage that it once was.

Perhaps the most important job of any CEO, whether of a central bank or a listed company, is institution building. Mark Carney promised to be the new broom at the BoE who would bring the bank into the 21st century, getting rid of many of the arcane practices which had become institutionalised over the years and improving diversity. I am not qualified to say whether he has succeeded in this goal but we hear good things about the working environment within the central bank. More importantly, perhaps, the BoE has taken on the regulation and supervision of around 1500 financial institutions over the past six years as the responsibilities of the central bank have evolved and the head of the Prudential Regulation Authority occupies one of the most senior jobs in the BoE.

One of those touted to succeed Carney is Andrew Bailey, head of the Financial Conduct Authority, an institution independent of the BoE which is charged with ensuring that “financial markets work well so that consumers get a fair deal.” Bailey is a former BoE official who has worked in an economics function, but crucially has a very strong background in regulation. It is an indication of the extent to which the BoE’s role has changed in recent years that Bailey is even in the running for the job.

The experience of the ECB President has been rather different since Mario Draghi took over in 2011. He is – probably rightly – credited with holding the European single currency bloc together during the Greek debt crisis by promising to do “whatever it takes,” despite opposition from representatives of other member states, notably Germany. Like the BoE, the ECB has also taken on greater responsibility for the regulation of financial institutions although unlike the BoE there is no suggestion that the potential successor to Draghi will need a background in financial regulation.

Interestingly, this paper by Prachi Mishra and Ariell Reshef makes the point that the personal characteristics and experience of central bank governors does affect financial regulation. “In particular, experience in the financial sector is associated with greater financial deregulation [whilst] experience in the United Nations and in the Bank of International Settlements is associated with less deregulation.” They go on to argue that their analysis “strengthen[s] the importance of considering the background and past work experience before appointing a governor.”

This is an important point. In 2012, when the BoE was looking for a successor to Mervyn King, the Chancellor of the Exchequer cast his net far and wide. Mark Carney got the gig because the government wanted an outsider to take over a central bank which was perceived to be too close to the institutions it was meant to regulate. Moreover, he had previous experience of running a central bank. But whilst Carney has done a good job over the past six years, I still believe it wrong to think (as the Chancellor George Osborne did during the hiring process) that filling this role is akin to finding a CEO of a multinational company, whose place can be filled by anyone from an (allegedly) small pool of international talent. They are an unelected official who holds a position of key strategic importance, enjoying unprecedented powers to influence both monetary policy and the shape of the banking system. In that sense it has never been clear to me that the interests of an outsider with no experience of UK policy issues are necessarily aligned with the UK's national interest.

Contrast this with the way the ECB process works. There are, in theory, 19 candidates for the top job amongst the central bank governors of EMU members, all of whose interests are aligned with those of the euro zone. In addition, there are another five potential candidates amongst the members of the Executive Board. Admittedly there is a lot of political horse-trading involved in the selection process, but there is no need to look for an outsider who may not necessarily be up to speed with the complexities of local issues, not to mention local politics which is increasingly a problem for central bankers (I will come back to this another time).

For the record, this is absolutely not an issue of economic nationalism – it is simply to remind those making hiring decisions that just because someone has done a similar job does not necessarily make them the best candidate for a position elsewhere. Indeed, if the evidence from the private sector is anything to go by, the continuity candidate may be the best person for the job: In the private sector, “firms relying on internal CEOs have on average higher profits than external-CEO firms”. And for anyone who doubts that the search for an external candidate will necessarily be an improvement over the local options, just ask the English Football Association about their experiences with Sven-Göran Eriksson and Fabio Capello.

A shot across the bows

It is now eleven years since the first indications of the looming financial crisis began appearing on our radar screens. In the summer of 2007, banks began to curtail redemptions from funds which were heavily invested in collateralised debt obligations and subprime bonds. This set in train a series of events that culminated in the bankruptcy of Lehman’s in September 2008, which triggered the biggest economic and financial crash in 80 years. A decade on, and we are only now beginning to see indications that the scars inflicted upon the industrialised world are healing.

The IMF’s World Economic Outlook, released today, points to a further pickup in global growth in 2018 to 3.9% which is the fastest since 2011. The regional composition also increasingly looks more balanced, with slower growth in China and clear signs of recovery in the euro zone. But weak productivity growth and wage inflation in the industrialised world mean that workers may not immediately feel the benefit. Moreover, as the IMF pointed out, even though the global economy is looking stronger, a combination of weak productivity and adverse demographics means that the long-term potential growth rate in the industrialised world will be far slower than in the years prior to 2008 (the same also holds for China which is increasingly an ageing society thanks to the one child policy introduced in 1979 though subsequently abolished in 2013).

This obviously poses a problem for central banks, which wish to take back some of the monetary easing in place for the last nine years, and although the Federal Reserve has begun the tightening process, weaker potential growth will mean there are limits as to how far it can raise rates. But the Fed’s actions – and perhaps more importantly, its rhetoric – have contributed to taking some of the edge off the market rally with equity indices still some way below their end-January highs. My recommendation at the start of the year to reduce the degree of risk exposure in investor portfolios has thus been borne out by recent events. Recall, too, that I expressed concerns regarding the reliance of the US equity rally in 2017 on tech stocks, and the sharp collapse in this sector over the past month affirms my belief that now is not the time for rational investors to be taking risks.

However, I am less sure of my prediction that equities have 5-10% upside compared to end-2017 levels. Aside from the fact that all the good news is already in the price, the trade dispute between the US and China has changed the landscape somewhat and raised uncertainty levels. The actions of central banks are also increasingly a complicating factor.

Whilst the Bank of England looks set to raise interest rates next month, taking them above 0.5% for the first time since 2009, the weakness of inflation and the prospect of a loss of momentum in the real economy suggests that the case for further tightening is weaker than a few weeks ago. Meanwhile, the ECB continues to keep its foot to the floor and its asset purchase programme is likely to continue for another six months. The prospect of a monetary tightening in the euro zone any time soon is remote. But as I have noted previously, there is an argument for more aggressive tightening on this side of the Atlantic. Forget about inflation – the strength of economic activity alone suggests that we no longer need monetary policy on a setting designed to cope with the problems of 2009.

But as one investor asked me today, will this not lead to an undesirable slowdown in activity? It might, but there is a good case for using fiscal instruments to offset some of the pain. After all, monetary policy has done much of the heavy lifting over the past decade, and as the IMF pointed out “all countries have room for structural reforms and fiscal policies that raise productivity.” If we do not see some form of monetary normalisation, central banks will not have much conventional ammunition left to cope with the next downturn. As the IMF’s chief economist Maurice Obstfeld wrote, “global growth is on an upswing, but favourable conditions will not last forever, and now is the moment to get ready for leaner times. Readiness requires not only cautious and forward-looking management of monetary and fiscal policies, but also careful attention to financial stability.”

Markets may not like this prescription, but they have had a good run since 2009 and now it is time to put monetary policy on a sounder footing. European central banks take note.

Asynchronicity

Comments by new Fed chair Jay Powell in Congressional testimony, suggesting that US interest rates might rise more rapidly than the markets currently anticipate, did nothing to assuage a jittery market which has been on edge since the beginning of the month. Powell indicated that his “personal outlook for the economy has strengthened since December” which has been interpreted as an indication that the Fed may be inclined to raise rates four times this year rather than the three that markets are currently expecting.

Such a pace of tightening would then put the upper limit of the Fed funds rate target corridor at 2.5% by year-end compared with just 0.5% in November 2016. That is not quite as aggressive as 2004-05 when the funds rate rose by 200 bps in the space of just 12 months, and a further 225 bps between May 2005 and June 2006, but having got used to a prolonged period of central bank inactivity over the past decade, that would represent a big move by the standards of recent years.

In addition, the Fed has already clearly set out a path for running down its balance sheet. Last June, it announced that it would reduce its holdings of Treasury securities at a rate of $6bn per month, rising by $6bn each quarter until it reaches a maximum drawdown of $30bn per month. Mortgage-backed securities are expected to decline by $4bn per month initially, with the drawdown rate being increased by $4bn per quarter up to a maximum of $20bn per month. By the end of this year, we can thus expect the balance sheet to decline at a pace of $50bn per month (ceteris paribus) which implies a $600bn reduction per year. If we assume that the minimum size of the balance sheet required to meet the cash needs of the US economy in future is around $2.5 trillion (it is currently at $4.4 trillion), the planned rate of reduction would enable this level to be reached by the middle of 2021 (see chart). This is at the lower end of the time period given by Powell in today’s testimony, when he said that a “normal” level will be reached in “three, four, five years.”

To the extent that the US economy looks to be back on its feet, posting solid growth and levels of unemployment consistent with full employment, monetary normalisation is clearly desirable. But with the duration of the US economic cycle already highly extended in the context of previous upswings, the fairly rapid degree of policy normalisation could be one of the factors which trips up either the economy or markets over the next one to two years. As the economist Rudi Dornbusch once remarked, “None of the post-war expansions died of old age. They were all murdered by the Fed.”

This also raises a question of how other central banks could or should respond. The ECB is well behind the Fed in the monetary tightening stakes, and is indeed still expanding its balance sheet even as the Fed is reducing its own. If the ECB starts to raise rates in 2019, it will be almost four years behind the US. The Bank of England may be less than happy about having to aggressively tighten if the UK economy suffers from any Brexit-induced weakness whilst the BoJ continues its extensive monetary easing. Such an asynchronous global monetary cycle might be expected to put upward pressure on the dollar. This is all very reminiscent of the situation in the late-1970s/early-1980s when Paul Volcker’s efforts to squeeze inflation out of the US economy necessitated a tight monetary stance which forced the greenback higher. This ultimately led to the Plaza and Louvre Accords of 1985 and 1987 which respectively attempted to weaken, and then stabilise the dollar.

Even today, old-timers in the FX market hark back to these agreements as an example of how to coordinate global monetary policy. We were reminded again in 2008-09 of the value of a co-ordinated policy stance. Today, we are nowhere near this position, and we can hardly blame the Fed for other central banks’ tardy efforts to remove the policies put in place in 2009 to combat conditions which are far different from those prevailing today. Whilst everything today appears to be going swimmingly, particularly in the euro zone, there will come a point where central banks elsewhere will have to start the process of taking away the punchbowl. Man cannot live by bread alone, but nor can he continue to rely on ultra-cheap credit.

Central banks and the digital currency revolution

In previous posts, I have argued that Bitcoin is a bubble which looks destined to burst. But bubble or no, the ideas underpinning digital currencies have piqued the interest of central banks which are aware of their potential. There are many reasons why they are interested in the digital currency revolution. For one thing, if such currencies take off as a medium of exchange, they will erode the traditional central bank monopoly over monetary issuance which in turn would reduce their control over the economy. As a result, there is an incentive for central banks to get involved if for no other reason than to head off the threat posed by private digital currencies.

Another argument in favour of a digital currency is that transactions using blockchain technology are transparent and traceable which would reduce the scope for tax evasion and illegal activity. In addition, it allows a greater degree of policy flexibility when interest rates are at the lower bound. In short, if we separate the unit of account function of money from its other functions by creating a parallel currency, it is possible to set an exchange rate between paper money and electronic money. By allowing paper money to depreciate (i.e. offering fewer units in exchange for the electronic alternative) this reduces the incentive to hold paper. In an environment where electronic currency is the dominant form, central banks have more flexibility to reduce the interest rate on deposits which does not exist in a paper cash economy. In a paper money world, if banks charge negative rates on deposits, individuals need only switch to zero interest bearing cash to avoid the negative charges.

This possibility is not available in an environment where digital currency is the only option: Account holders would have to store it in some other asset outside of central bank control.
In order for such a system to work relies on adapting a blockchain, or electronic digital ledger, which can be controlled centrally rather than relying on the distributed ledger technology currently employed by Bitcoin. As it currently stands, blockchain relies explicitly on a community of mutually distrustful parties to ensure that transactions are recorded correctly. Precisely because nobody trusts anybody else, no single individual or entity controls the digital record. Instead, the settlement technology relies on an encryption system to ensure that all users have access to the ledger simultaneously and each of them can update it. But the form of blockchain used to generate Bitcoin suffers from a number of technical limitations which will preclude the wider use of this particular digital currency.

For one thing, it can only process a relatively small number of transactions. The Bitcoin network can currently only process 7 transactions per second (tps) whereas the credit card Visa has a peak capacity of 56,000 tps and handles 2,000 tps on average. For a currency with aspirations to widespread acceptance this is a huge limitation, and is one of the reasons why I continue to believe that the upside for Bitcoin is limited. The obvious solution to the Bitcoin problem is to raise the size of the data blocks (currently, their size is limited to one megabyte which takes 10 minutes to process). Efforts to get all the Bitcoin miners to agree an increase in the size of the blocks has proved extremely difficult with the result that the blockchain has split once already this year, with one group opting to remain on the current standard and the others going off to form a parallel digital currency with fewer such technical constraints. Ironically, the Bitcoin system was initially designed to run at twice its current speed but it was limited for security reasons.

Indeed, security concerns may well be one of the issues which undermine Bitcoin. In theory, so long as no miner can control more than 50% of the network, they are unable to falsify the chain. But there have been well-publicised instances where Bitcoin exchanges have been hacked so it is clearly not as safe as its proponents believe. Moreover, if one individual or a colluding group of miners is able to gain more than 50% of the total network computing power they will technically be able to force a break in the chain, allowing them to override the rest of the community and take over the chain. Raising the size of the blocks in the chain could inadvertently lead to such an outcome. Miners with access to huge computing power and very low energy costs would be better placed to afford more bandwidth, which may lead to a higher concentration of miners.

So where do central banks come in? One possibility is that they create a centralised digitally encrypted record which would get around the security problems in the current system, Indeed, the system on which Bitcoin is based operates very much like the wild west – if there is a problem you are on your own, as there is no-one to turn to. By acting as the guarantor of the system, central banks eliminate this problem. In such a system, it is envisaged that individuals would hold a digital wallet at the central bank, with their incentive to do so enhanced by the differential rates of return offered on digital and paper money, outlined above.

But what happens to commercial banks in a system where the central bank manages the transactions and creates the digital currency? One possibility might be that banks create their own digital currency which can be exchanged for the central bank unit at a given rate. This would allow banks to create credit in the same way they do now whilst giving central banks the ability to control the overall rate of credit creation by altering the digital currency exchange rate.

Other alternative central bank currency models appear to ignore the commercial banking system altogether, relegating them to the role of transaction processors. In such a world, banks manage a number of lower-level chains which record transactions, and which in turn feed into the main ledger to which only the central bank has the digital key. Essentially, banks would become transaction verifiers rather than account holders. Since the costs of becoming a transaction verifier are far smaller than operating a fully-fledged bank, this might be expected to raise banking competition as new entrants come into the market which will reduce the costs of banking for the wider public.

We are obviously a long way from being able to introduce this kind of system. But it does suggest that the theoretical possibilities of a digital currency system are far greater than the relatively narrow range of outcomes offered by Bitcoin. This is one of the key reasons why we should not dismiss the digital currency story. However, it does not always pay to have first mover advantage. Recall that the mid-1970s Betamax technology, which was many people’s introduction to home video, was quickly supplanted by the technologically inferior VHS system, which in turn gave way to the DVD revolution. Home video was once a big deal, but who remembers Betamax today? We could be saying the same thing about Bitcoin in the years to come.

Monetary policy complications

A couple of months ago I wrote a post (here) which posed the question whether we knew what was really driving inflation. Last month, Claudio Borio, head of the Economic and Monetary Department at the BIS, delivered a speech (here) asking a similar question. Borio raised three key issues:

1. Is inflation always and everywhere a monetary phenomenon, as claimed by Milton Friedman? Or do real factors play a much bigger role than often assumed? 
2.  Are we underestimating the influence that monetary policy has on real interest rates over longer horizons?
3. If these two claims are true, does it then follow that central banks should place less emphasis on inflation in designing monetary policy, and more on the longer term effects of monetary policy on the real economy through its impact on financial stability?

In short, Borio's answer to these questions is broadly yes. In the case of (1) he argues persuasively that the forces driving inflation are increasingly global, rather than local, with technological change and the entry of billions of new workers into the global workforce as a result of globalisation being primary contributory factors. Ironically, the economics profession generally believes that immigration has little impact on local wages but that raising the global supply of labour impacts upon global wages. That is a circle which needs to be properly squared.

With regard to (2), Borio uses a range of historical examples to indicate that the impact of monetary policy, via its influence on expectations, can have far longer-lasting implications on the real economy than is conventionally supposed. In other words the neutrality of money, which forms a key assumption underpinning much of modern macroeconomics, can be called into question. The logical conclusion is thus that a monetary policy purely focused on inflation can have dangerous side effects which cannot be ignored. Indeed, Borio argues for the "desirability of great tolerance for deviations of inflation from point  targets while putting more weight on financial stability."

I find this set of arguments highly convincing. Indeed, it is difficult to dismiss the thought that QE, which reduces interest rates and prompts a bubble in the price of other assets, ultimately impacts upon decision making in the real economy. For example, it prompts indebted firms to issue additional debt to fund capital expansion – hence the boom in the high yield debt market – which may ultimately come to a sticky end if interest rates start to rise.

A further suspicion is that the current monetary policy model is merely the latest in a long line of fads which may well be junked when (or if) it proves not to work. This chimes with the view expressed by Charles Goodhart[1] who has pointed out that since the 1950s there have been broadly three fashions in policy. From the 1950s to the mid-1970s, monetary policy was focused on labour markets and the bargaining power of unions. As the economics profession increasingly realised that simple Phillips curve analysis was insufficient to explain the relationship between inflation and unemployment, policy between the late-1970s until the 1990s switched to looking at money and monetary aggregates. But as this approach also failed to deliver control of inflation, the thrust of central bank policy switched to the NAIRU and the influence of expectations. But if Borio is right, this may simply be another in the long line of transitory policy fashions if it proves to have adverse longer term consequences which require more rapid-than-desired policy adjustment.

Indeed, central bankers will readily agree in private that they do not know what are the long-term implications of the current monetary approach. In particular, the impact of low interest rates on depressing pension returns is a problem which will only become apparent over a multi-year horizon. In effect, society has been forced to choose between protecting employment and labour income today at the expense of lower pension returns tomorrow. The jury is out as to whether it is a worthwhile trade off.

The question of whether the BoE should raise interest rates in the near-term should be seen in this context. On the one hand, there is a strong case for suggesting that rates are too low given the overall macroeconomic picture which is helping to exacerbate asset price distortions. But it is less clear that inflation should be the trigger for higher rates. Admittedly, inflation is running well above the 2% target. But wages remain muted and given the backdrop of Brexit-related uncertainty, they are likely to remain so.

It is hard to avoid the suspicion that justifying a monetary tightening on the back of inflation is a convenience which the general public can readily understand. Whilst households may not like it, higher rates may in fact be in the best interests of the economy. Not because there is an inflation problem, but because it might be the first step on the road towards taking some of the air out of the asset bubble which has built up in recent years. It may also help to give us a little bit more retirement income too.

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[1] Goodhart, C. (2017) Comments on D Miles, U Panizza, R Reis and A Ubide , “And yet it moves – inflation and the Great Recession: good luck or good policies?”, 19th Geneva Conference on the World Economy